the acquisition would be $900. But this would not be optimal for the
acquirer. The acquirer would rather purchase TS for $950, structure the
acquisition as a stock purchase, and after purchasing the stock make a 338
election, since the after-tax cost would be $787.71. The actual transaction
price would lie between $950 and $1,091.79, because for each dollar above
$950, the cash position of TS’s shareholders would exceed $760 and the
after-tax cost would be more than $787.71 but less than $900.
Compare this outcome to that for TC. The optimal structure of the acqui-
sition is a stock sale. The 338 election results in a higher after-tax cost for the
acquirer than does a straight stock transaction or an asset sale. Shareholders
of TC will not agree to an asset sale, because after taxes they wind up with less
cash than they would under a stock or stock and a 338 election acquisition
structure. Hence, TC will be sold for $900 and structured as a stock sale. In
contrast, TS will be structured as a taxable stock sale with a 338 election. The
transaction price will be at least $950, or $50 plus more than TC’s transaction
price of $900. This result reinforces the conclusion that an acquirer will pay
more for an S corporation than it will for an equivalent C corporation, even
under the assumption that the present value of after-tax cash flows are equal.
As the earlier examples of the value of tax saving demonstrated, this is not
likely to be the case. When one adds the income tax advantage of an S to its
advantage when a transaction takes place, then the S premium is likely to
exceed the minimum 5.56 percent [($950 ÷$900) −1] in the example.
TAX-FREE ACQUISITIONS OF FREESTANDING
C CORPORATIONS
As is clear from the preceding discussion, the relationship between tax struc-
tures and value is quite complex. An in-depth discussion of these issues is
beyond the scope of this book. However, for completeness, here is a summary
of the main points that influence the structure of tax-free acquisitions and
divestitures:
■ The most common tax-free reorganization structures are 368(a), (b),
and (c) reorganizations.
(a) reorganizations are statutory mergers.
(b) reorganizations require that the acquirer purchase at least 80 per-
cent of the target’s stock in exchange for the stock of the acquirer.
(c) reorganizations require the acquisition of virtually all of the target’s
assets in exchange for the acquirer’s stock.
■ For a transaction to qualify as a tax-free reorganization it must have a
sound business purpose, demonstrate a continuity of shareholder inter-
est, and offer a plan to continue the business.144 PRINCIPLES OF PRIVATE FIRM VALUATION